Deciding what to do with your 401(k) plan when you change jobs

If you participated in an employer-sponsored plan such as a 401(k) plan and you are planning to leave your job, or have already left, you will need to make a decision on what to do with you 401(k) plan money. Typically, there will be several options available to you. You can withdraw all of your money in a lump sum distribution, but that is generally never recommended because there may be severe tax consequences and early withdrawal penalties that may apply. You can leave the money in your current 401(k) plan, or you can roll over your funds into an IRA or your new employer's retirement plan. Make sure to carefully consider the tax consequences of each option and how exactly your retirement savings will be affected before making any decision.

So when you leave you job, what should you do with your 401(k) plan. Should you just leave it alone, or take it? Should you roll it over to your new employer's retirement plan or roll it over to an IRA?

When weighing out your options, you should keep in mind that the major advantage behind a 401(k) plan is that it allows you to invest your money and save for your retirement on a tax-deferred basis. So when you switch jobs, it is generally the best idea to continue the tax-deferral nature of your retirement account, and avoid any current taxes and/or penalties that can easily deteriorate your retirement savings.

Take the money and run
When you are leaving your current employer, you can just take your money out of your 401(k) in a lump sum. To move forward with this option, all you need to do is contact your 401(k) plan administrator and instruct them to write you a check. Afterwards, you can essentially do whatever you want with your retirement money. After paying taxes and/or penalties, you can use the funds to meet your short-term expenses such as any bills you may have or medical expenses, or put the money down for a home purchase, or invest the money elsewhere.

While taking your money in one lump sum withdrawal may seem like a very tempting idea, it is almost never a good option. Taking a plain lump sum distribution can wreak havoc on your retirement savings and potentially affect your future retirement goals. Therefore, unless you need the money immediately and there are no other alternatives, it is not advisable to take a lump sum distribution from your 401(k) plan. Not only will you lose your tax-deferral advantages of your 401(k) account, but also have to payout immediate tax consequences and perhaps other penalties.

Firstly, you'll pay federal and state income taxes on the money you withdraw with the exception of any after-tax contributions you've made. In the event that the lump sum is large enough, you can push yourself into a higher tax bracket for the current year you decide to take the distribution. If you make this withdrawal before the age of 59 1/2, you'll have to pay a 10 percent early withdrawal penalty in addition to your income tax liability unless you qualify for an exemption, which is difficult to do. For example, one exemption that exists is that if you leave your job and you're 55 years or older at the time, you may be exempt from the penalty. Moreover, many people may not know this, but your previous employer is required to withhold 20 percent of your distribution for federal taxes, so the amount of cash that you receive will automatically be diminished by that amount, which may be unexpected to you.

Note: Because lump sum 401(k) distributions will spark many tax consequences and may be a complex transaction, it is advisable that you consult a tax professional for more information on the issue.

Note: If your 401(k) plan allowed after-tax contributions or Roth-type contributions, any qualified distribution from Roth contributions and/or earnings will be tax-free for federal income tax purposes. If you take a non-qualified distribution from a Roth 401(k), only the earning will be subject to income taxes and/or early withdrawal penalties.

Leave the funds alone
Another option when you leave your employer is to leave your retirement funds in your previous employer's 401(k) plan where they will continue to do what they have been doing while you were employed.

However, you may run into issues when trying to opt for this option, because of your account is only vested $5,000 or less, your employer can require you to take the money out when you leave the company.

Leaving money with your previous employer's 401(k) plan can be a good idea if you're happy with the investment offerings or while you're exploring alternative options. Furthermore, if your new employer has 401(k) participation restrictions such as on the amount of time worked before being eligible to participate. When the restriction is up, you can have your previous employer's 401(k) plan administrator transfer the funds to your new employer's retirement plan. This may not always be the case since some 401(k) plans don't allow for rollover contributions. Contact your new plan administrators for instructions on the matter.

Transfer the funds directly to your new employer's retirement plan or to an IRA
Instead of withdrawing your money, you can always opt to roll over your old 401(k) funds to your new employer's 401(k) plan if the new plan will accept such contributions. You can just as easily and perhaps more importantly roll over all your 401(k) funds to a traditional IRA that you already have or open a new IRA to accept those funds. There are no limits on how much you can roll over into an IRA.

You may also want to consider converting your 401(k) funds to a Roth IRA. The portion that you convert to a Roth IRA that is considered a taxable distribution will be included as part of the your income for the current year for income tax purposes.

Any Roth contributions that you’ve made to your previous employer's 401(k) plan can only be transferred into a tax-like-retirement-vehicle such as a Roth IRA, Roth 401(k), or Roth 403(b).

Typically, the best way to go about rolling over your funds to an IRA or new employer's 401(k) plan is to instruct your 401(k) plan administrator to directly transfer your retirement plan assets. This way you can directly transfer your funds from one trustee or custodian of a retirement plan to another trustee or custodian. It is a simple process that allows you to continue your tax-deferral advantages without any interruptions. Using this process, the money never moves through your hands. And, more importantly, if you follow federal rollover rules, your roll over of your 401(k) funds will not be subject to the 20 percent federal income tax withholding.

Note: In some cases, your old retirement plan may cut you a check and mail it to you in the name of your new custodian or trustee of you IRA or new employer-sponsored plan. Don't be concerned, this is still considered to follow the federal rollover rules. Bring the check to the custodian or trustee.

Which option is right for you?
If your new employer allows a retirement plan that will take rollovers, is it better to roll over your money into your new employer's 401(k) plan or to a traditional IRA?

Here are some things to consider when making the decision:

• A traditional IRA can offer you the universe of investments while a 401(k) is extremely limited, restricted in the types of investment options it can allow
• A traditional IRA is managed by professional money managers, while a 401(k) plan in unmanaged
• A traditional IRA can be converter to a Roth IRA
• A 401(k) plan offers creditor protection more so than an IRA
• A 401(k) plan allows for loan provisions, which means that you can have the flexibility to borrow money from your 401(k) plan.

Your Isakov Planning Group Financial Advisor can help you evaluate your options and help you decide which one of these options is best suited for your situation. Speak with your Financial Advisor before deciding what to do with you 401(k) fund.